by Erik L. Knutzen, CFA, CAIA, Chief Investment OfficerâMulti-Asset Class, Neuberger Berman
Last week, the worldâs major central banks marched on from the fight with COVID-19 and started maneuvering their troops for the coming battle against inflation.
A day after the U.S. Federal Reserve revealed its plans, and a few hours after the European Central Bank declared its position and the Bank of England fired its first shot, Neuberger Bermanâs Asset Allocation Committee met to discuss its 12-month views for 2022.
Weâll be publishing our thoughts in full early in the new year. Hereâs our first dispatch from the frontline.
A Positive But More Volatile Year Ahead
Asset Allocation Committee members broadly agreed on two things.
First, we agreed that next year is likely to be a tolerable year for growth and risky assets, with equities outperforming credit and credit outperforming government bonds. Any downside in equity multiples or high yield bond prices caused by rising real rates is likely to be more than offset by earnings growth and carry, respectively.
That said, there was also consensus that the campaign is likely to be more volatile and challenging for investors in 2022 due to higher rates and tighter financial conditions as we grapple with inflation and move deeper into the middle part of the business cycle. Hence a âtolerableâ year and not another âgreatâ one like 2021. As Joe Amato wrote last week, the S&P 500 Index cannot go up 20% a year indefinitely.
There was less agreement about when during the year the major bouts of volatility are likely to strike. And our debate centered on how markets would react to the factors that we all agree are the most important: inflation, central bank policy and the path of real rates.
More Hawkish
That is why last weekâs news was so important for next yearâs outlook.
Norwayâs central bank hiked rates for the second time this cycle. The Bank of England raised its rate for the first time in more than three years. Even the perma-doves at the ECB announced that they would taper their Pandemic Emergency Purchase Program by March (albeit cushioning the blow with their existing asset purchase program).
The Federal Reserve committed to completing its tapering by March. Moreover, its âdot plotâ now suggests three rate hikes next yearâthree months ago its policymakers were not even sure there would be one. Chair Jerome Powell sounded notably more hawkish on inflation and the jobs market.
As Robert Surgent wrote three weeks ago, we think that investorsâ response to tapering could teach us a lot about the likely path of markets through the rest of this cycle. So far, the market reaction to these initial statements of intent has been mixed.
On the day of the Fed meeting itself, Treasuries and the dollar barely moved, and equities ralliedânot only small caps and value stocks, but also the large cap growth and tech stocks that might be considered vulnerable to higher real rates. By Thursday, as the Bank of England and the ECB joined the fray, Treasuries maintained their bid, but growth and tech stocks were down again, dragging the S&P 500 Index with them. At time of writing on Friday, that pessimism was still in place.
Markets to Repriceâbut When?
Thursdayâs price action could be seen to support those on the AAC that think the main period of volatility in 2022 will come earlier in the year. My own sympathies lie there.
If tapering is done by March, with the Fed confirming that it could then move straight on to rate normalization, we could well have two hikes in the bag by midyear. As liquidity drains from markets, nominal rates edge upward and inflation begins to ease, real rates rise, equity valuation multiples contract and investors reprice for generally tighter financial conditions. According to this scenario, markets ought to have all the information they need to reprice, leading to volatility and downside in risky assets before midyear.
Wednesdayâs more positive price action might support the other side of the debate, which anticipates a more positive first half of 2022 before things get sloppy in the second half.
The argument here is that overall economic momentum remains strong and markets are welcoming central banksâ decisive moves, seeing them as the short, sharp attack that will likely move us into a less inflationary midcycle expansion, with fewer subsequent rate hikes required.
If victory can be declared that quickly, 2022 could be a smoother year than we expect. But the proponents of this second view note that fixed income markets have priced for a very big drop in inflation in the latter half of the year, and they are skeptical. Should inflation prove more stubborn than expected, investors may conclude that the heavy artillery of positive real rates is required to win the battle, with all the implied collateral damage. Some AAC members argue that this could be the catalyst for more turbulent repricing in the second half of the year.
A Tougher Fight
To summarize, the AAC is confident that asset allocation is likely to be a tougher fight next year than it was this year. We are also confident about what the battlefields for markets will beâinflation, central bank policy, real rates. Where debate still rages, itâs over how the dynamic could play out through the course of 2022.
Our forthcoming Asset Allocation Committee Outlook will explore this question in more detail, as well as what it means for our investment view.
The way this debate resolves will likely determine our tactical views through the course of 2022. As we step back to consider where we believe we will be 12 months from now, the earnings growth and carry we anticipate over the next 12 months make the case for a positive view on risky assets, but with a heightened sense of caution and a renewed focus on strategies that can help cushion or take advantage of anticipated volatility. It promises to be yet another interesting year.
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